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Are the prices of cryptocurrencies being manipulated?

July 2018

ByJordan Underhill, J.D., CFE

Investors and regulators are concerned that cryptocurrencies are highly susceptible to price manipulation. This danger is particularly pronounced for the hundreds of small, thinly traded “altcoins” that have popped up in the wake of the success of bitcoin and Ethereum. In
February, the Commodities Futures Trading Commission (CFTC)
issued an advisory warning investors that these small virtual currencies are targets for pump-and-dump schemes.

However, concerns about price manipulation aren’t limited to smaller currencies. On May 24,
Bloomberg reported that prosecutors at the U.S. Department of Justice (DOJ) were working with the CFTC to investigate the potential price manipulation of bitcoin, Ethereum and other currencies. While it’s unclear how wide-ranging this probe is, one possible focus might be whether traders are abusing another
cryptocurrency — tether — to influence the price of bitcoin.

Tether, one of the most widely traded cryptocurrencies, typically accounts for around 20 percent of trading activity on a given day. It’s sometimes called a “stablecoin” because it’s advertised as being backed by U.S. dollars. (While the company behind tether, Tether Limited, recently
published a three-page report by the law firm Freeh, Sporkin & Sullivan LLP stating that the company had sufficient capital to back existing tether coins, the law firm didn’t conduct an official audit. Thus far, no external audit has been produced to verify the claim that each unit of tether is backed
by $1. Tether currently has a market cap of more than $2.7 billion.)

Because its value is pegged to U.S. dollars, tether provides a stable store of value for traders in an otherwise volatile market. Additionally, tether is an attractive way to move money into and out of virtual currencies because it enables quicker transactions than wire transfers of fiat currency.

On June 13, University of Texas finance professor, John M. Griffin, and doctoral student, Amin Shams,
published a paper arguing that price manipulation played an outsized role in bitcoin’s rise in value during 2017. In the paper the authors argue that half of the increase of bitcoin’s price in 2017 could be traced to periods following the creation and
introduction of tether to various cryptocurrency exchanges, typically while the price of bitcoin was in decline.

Griffin and Shams write that these periods aren’t consistent with investor demand, suggesting that tether may have been used to artificially support the price of bitcoin. Importantly, the organization behind tether shares management (including the same CEO) and ownership with the company that operates Bitfinex,
one of the largest cryptocurrency exchanges. This relationship raises a potential conflict of interest — namely, that the operator of a cryptocurrency exchange has an interest in promoting the ongoing trading of cryptocurrencies.

An ascending currency is likely to generate more sustained trading activity than a currency in decline. Additionally, the company behind the exchange (and its employees) might have cryptocurrency investments. Thus, a company that controls both a highly traded cryptocurrency and a popular crypto exchange could have
the motivation and ability to influence prices in its favor. In December, the CFTC reportedly
issued subpoenas to the companies behind Bitfinex and tether. However, the scope of these subpoenas is unclear and they aren’t necessarily related to the CFTC’s price manipulation probe.

According to Griffin and Sham, entities associated with the Bitfinex exchange used tether to purchase bitcoin when its price was falling. This conduct might help explain bitcoin’s growth from less than $1,000 in January 2017 to a high of more than $19,000 in December. Since December, bitcoin has been on a rocky decline back
to the $6,000 to $7,000 range. (See
Bitcoin tops record $19,000, then plunges in wild 2-day ride, by Evelyn Cheng, CNBC, Dec. 6, 2017.)

Bloomberg recently
released an investigation into tether trading activity, which focuses on more than 56,000 tether trades made on another popular exchange, Kraken, from May 1 to June 22. Bloomberg’s report found that many tether trades on Kraken were oddly specific. The third-most
commonly occurring trade in Bloomberg’s data was for 13,076.389 tethers (the first and second were for 75 and 1,000, respectively).

Additionally, some orders went out to five decimal places. This investigation also found that in periods of significant market activity, tether’s price barely moved. That is, large purchases of tether often failed to increase its market price.

Highly specific trades and a lack of price movement might be indicators of “wash trading” — a form of market manipulation where the same trader (or group of traders) buys and sells an asset to create the illusion of natural market activity. While many markets have safeguards in place to prevent this type of
manipulation, cryptocurrency exchanges often operate outside of existing financial regulations.

While the Griffin and Sham paper and the Bloomberg report aren’t necessarily conclusive of market manipulation, they do identify red flags and provide a nuanced look at the vulnerabilities of cryptocurrencies. Additionally, these reports are indicative
of the persistent anxiety that surrounds the rapidly growing, but largely unregulated, crypto market. Many investors and financial institutions are reluctant to enter the market because of concerns about fraud and other criminal activities.

Thus, investors and crypto enthusiasts will closely watch the results of the DOJ and CFTC probes. A finding that there’s little, if any, manipulation in the crypto market would be a boon for bitcoin and related currencies. On the other hand, if these
agencies uncover significant price manipulation, the market’s likely to sink lower.

Jordan Underhill, J.D., CFE,
is an ACFE legal writer. Contact him at junderhill@ACFE.com.

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